This article was originally published on Forbes on May 13, 2022,01:26pm EDT

This year, cloud investors have been given a dose of reality on how the market prices growth in this category. For Cloudflare, revenue growth is not an issue at this time. Yet, revenue growth is less meaningful in the current macro environment if the growth does not translate to a healthier bottom line.

It’s true that cloud is deflationary, which is why companies in this sector may continue to see growth during times of inflation. Yet it’s also true that cash is becoming more expensive, and therefore growth must be balanced with a stronger bottom line.

Product Overview

Cloudflare has a formidable customer base and owns the predominant share of the Content Delivery Network market. According to the data from W3Techs, 81% of the websites that use CDN or reverse proxy rely on Cloudflare with a strong presence in small to medium-sized businesses (SMBs).

We had discussed in a podcast on tech stocks last year that Cloudflare is strong in the small to medium-sized business (SMB) category and offers free entry-level services. The company benefits by converting the free customer base to paid services, and it can also use the free customer base to test any new features before they are launched. Cloudflare has been able to upsell its products with a dollar-based net retention rate that increased by 400 basis points YoY to 127% in the recent quarter.

Zero Trust Security is gaining prominence due to rising security threats as the data is not stored in one place. Secure access service edge (SASE) is a cybersecurity concept that utilizes Zero Trust to identify users and devices to deliver secure access to specific applications or data.

Cloudflare One is the company’s flagship Zero Trust network-as-a-service. The need for this has grown due to remote teams as SASE allows policy-based security no matter where the user, application or device is located. Zero Trust Security is built on the premise that no one should be trusted within or outside the network. In the traditional security systems, it is difficult to obtain access from outside the network while those located inside the network were trusted. With Zero Trust, these trust assumptions are removed with tools such as multi-factor authentication, giving access for a limited time and to also verify, authorize and to have a continuous check on all the data points that are given access.

Zero Trust has helped the company to increase its Total Addressable Market from $32 billion in 2018 to about $100 billion in 2024. The company is playing a major role in the transition from a traditional hardware-based security approach to modern zero-trust security.

In late September, Cloudflare company announced its R2 storage product. You can see the dark purple line start a sharp rise upward following the start of October. R2 storage allows unstructured data to be stored without egress bandwidth fees, which are charged when developers retrieve data from a cloud provider like AWS. The egress fees are essentially a tax without any value. Markups are as high as 7900% in the United States region when calculating what AWS charges. This is an 80X bandwidth markup and was detailed here by Cloudflare’s management.

Primarily, Cloudflare is hoping to attract developers for its Workers product, which is a serverless compute service for developers to build applications and deploy code at the edge. This removes the need for developers to maintain servers or spin-up containers. The cloud service provider (in this case, Cloudflare) provisions, scales and manages the infrastructure required to run the code. Cloudflare wants developers to choose them over the larger cloud providers because of their location at the edge.

Cloudflare’s Q1 Earnings

At the time the low-cost R2 cloud storage service was launched, Cloudflare’s CEO has stated “we’re aiming to become the fourth major public cloud.” Big Tech has the advantage of strong margins and quite a bit of cash on the balance sheet to build out cloud infrastructure. For this ambition to materialize, not only must Cloudflare build more Points of Presence (PoPs) but the company must also undercut AWS on egress fees, for example, in order to remain competitive.

In the current quarter, network capex was 9% of revenue. For the full year, the network capex is expected to increase to 12% to 14% of revenue. I believe this is a primary reason Cloudflare’s valuation could come under pressure.

Note: we covered Cloudflare previously for Forbes here: Cloudflare Stock: Ambitious Company Must Prove Its Valuation

Here is what the company said on the call:

I think the thing which is powerful about as we build out more POPs is that counterintuitively, because of the design of our network and because of the efficiency of our network that both Thomas and I just alluded to, it actually drives our cost down over time rather than driving it up. It takes a certain amount of servers in order to process a certain number of requests. So your CapEx is actually driven by the amount of usage of your service more than anything else.

What is powerful is because we have done the hard work on the networking and software side to make it so that any server, anywhere can handle any request, that means that as we continue to expand our network out that we're able to directly interconnect with the various ISPs and eyeball networks around the world and drive our cost down for things like bandwidth, co-location and other variable costs that are part of our business.

At this time, revenue growth is not an issue for Cloudflare as it’s been quite robust for many quarters. The company reported 54% revenue growth beating estimates by 6% with 49% growth expected next quarter. The company raised full year revenue guidance to $957 million, at the mid-range, for growth of 46%.

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There is additional supporting evidence that growth will not be an issue for Cloudflare, including remaining performance obligations (RPO) up 57% year-over-year and dollar based net retention up 400 bps YoY. Customers paying over $100K increased 63% year-over-year to 1,537. This outpaced total customer growth of 29%. Notably, the >$100K segment was a deceleration from 71% in the previous two quarters.

Large customers contributed 58% of revenue. There was solid growth in the >$500K customer base of 68% year-over-year growth and >$1 million customer base grew by 72% year-over-year.

The company has a gross margin of 77.80% but had a GAAP operating margin of (18.90%) and adjusted operating margin of 2.30%. The primary difference being stock based compensation which doubled to $34 million in Q1, up from $18 million in the year-ago quarter.

Similar to the note about network capex, the company is stating they will not see improvement to operating margin in the near term. I believe this could put pressure on valuation if cloud peers are able to improve operating margin during the current macro environment.

Here is what management said:

“We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”

Free cash flow was negative $64.4 million (30% of revenue) in comparison to a negative $2.2 million (2% of revenue) in Q1 2021. Of this, $30 million was due to a unique withholding tax payment in the recent quarter. This would still show a marked decline in free cash flow from last quarter during a time when the market is especially sensitive to cash flows. The company reported positive free cash flow of $8.6 million in Q4 2021, and it was the first positive free cash flow quarter since the company became a public company. Management stated they will be cash flow positive in the second half of the year while the first half of the year will have negative free cash flow due to the investment in network and redesigning of physical offices post Covid-19.

The company had cash and available-for-sale securities of about $1.7 billion, out of which cash is $152 million.

Conclusion:

Cloudflare is showing strong customer growth and its steady revenue growth also helps substantiate that cloud is, indeed, deflationary. What is likely weighing on the market’s mind is what the CapEx will be to become the fourth cloud provider. Management has confirmed that operating margin will not improve anytime soon as the company plans to re-invest and the company’s recent quarter showed a decline in free cash flow. The I/O Fund exited the stock based to focus on higher conviction companies that have a better cash flow margin.

Royston Roche contributed to this article.